While there’s no magic bullet, no unknown loophole to elude the IRS , with some advance planning, small business sellers may be able to lower their tax burden. The tax laws are so complex, and business situations so diverse, that tax and legal professionals should be consulted before any transaction is entered into. So rather than providing step-by-step instructions for reducing your taxes, we’ve compiled a list of basics to discuss with your tax advisor both in advance and at the time of a sale.
If you are several years from selling your business, consider…
The Benefits of Gifting.
If you have been thinking about making gifts to family members, there are some planning opportunities that are unique to business owners. By gifting a portion of the company to family members or to trusts, owners can take advantage of the minority interest and “lack-of-marketability discounts” allowed by the IRS . These discounts typically range between 15% and 30%. The discount allowed becomes less the closer to the sale the interest is gifted. By transferring interests in the business at a discount as opposed to gifting cash (where there is no IRS discount) business owners have opportunities to cut their total tax bill.
Converting to an S Corporation.
If your business is currently a “C” corporation, there may be an opportunity to save taxes upon the sale of your business by converting to an “S” corporation. By converting to an S corporation, you will mitigate the corporatelevel federal tax on the increase in value of your business between the date of conversion and the sale. Any “built-in-gain” (excess of value over tax basis) that existed on the effective date of the S election will continue to be subject to the federal tax for 10 years. For this reason, the more time between the conversion and the sale, the better the tax savings.
If you are ready to negotiate a sale, consider…
Entity vs. Asset Sale.
Consider the consequences of selling your company (entity sale) versus selling your company’s assets (asset sale). Buyers and sellers often have very different interests when negotiating a business sale. For example, in an entity sale, the gains from the sale are subject to capital gains tax instead of income tax (good for the seller). However, the buyer can write off assets as a tax deduction, but not the purchase price of the stock.
Allocation of Purchase Price.
If you decide to negotiate a sale of assets (as opposed to stock of your company), it is important to focus on the allocation of the purchase price, since there can be different tax consequences to both the seller and buyer. The seller will want as much of the purchase price allocated to intangible assets, such as goodwill, as possible. Goodwill is a capital asset and the gain will be taxed at the 15% long-term capital gain tax rate, assuming the entity has been an S corporation since inception or for more than 10 years. The buyer then can write off the amount allocated to goodwill over 15 years.
However, the buyer may want to allocate more of the purchase price to fixed assets, such as machinery and equipment, which he can write off over five to seven years. Allocating some of the purchase price to these assets may cause the seller to have ordinary income and be taxed at a 35% rate instead of a capital gain taxed at 15%. While the allocation of the purchase price must be based on fair market value of the assets, there is usually some room for negotiation.
State and Local Tax Considerations.
Don’t lose sight of the state and local tax consequences, including sales and transfer taxes. In certain situations, the federal income tax consequences may be the same, whether the transaction is an asset or entity sale, but the state and local tax consequences may be the deciding factor as to what structure to use. If your entity has been an S corporation from its inception, it still may make sense to sell the entity instead of selling the assets, where a state or local income tax would be incurred by the corporation on an asset sale.